Friday, June 8, 2012

Some notes on market measures of inflation

I learnt some interesting facts about inflation-linked investment products. To begin with Sober Look had an intriguing chart showing an inversion in the TIPS yield curve.

Michael Ashton at Epiphany had an interesting explanation for this. Basically, short-dated TIPS begin to trade like gasoline futures. Like zero-coupon inflation swaps, TIPS are indexed to headline inflation, not core inflation. The most volatile component of headline inflation are gas prices, although in general large changes in gasoline prices will mean-revert to core inflation. We've had a large fall in gas prices, so near TIPS have fallen in value. More distant TIPS price in an expectation of gasoline reverting to core, and therefore are less sensitive to the fall in gas prices.

I learn here that the 5Y 5Y forward inflation curve is the market price for an inflation swap that starts in 5years and ends in 10 years.

In this post at David Glasner's blog, I point out that the fall in TIPS prices might not necessarily be a negative indicator. Starting with Michael's point about the sensitivity of near TIPS to gasoline prices, how much of the fall in gasoline prices is linked to fears of deflation, and how much to the massive rise in crude oil inventories coursing through North America? Domestic crude oil production is skyrocketing due to the technical combination of horizontal drilling and multiple stage fracturing. If this technological leap has contributed to the fall in energy prices, and the fall in energy prices has contributed to the fall in TIPS prices, then there is some component of ingenuity, and not wholly pessimism, at the core of the fall in TIPS prices.